Equity Markets and Economic Development: What Do We Know

the bank’s subjective expected variance in the distribution of riskiness of group j should be
larger than the other group i. As a consequence, the banks' expected return from lending to
group i can be higher than that to group j (i.e., EΠi*)EΠj * ), although the expected
productivity of the latter is higher than that of the former (i.e.,Ri{Rj). This results in a
suboptimal allocation of savings.

Turning to equity markets, investors do not take default risk into account as their expected
returns EΠj* are equivalent to the project’s expected return, i.e. EΠj* = Rj . Potential
shareholders pick up their investment decisions based on comparison of expected
productivities, which are known. This allows riskier groups (such as group j) to obtain
financing. The model concludes that equity market development contributes to full capital
allocation efficiency, especially in the presence of information assymetries in the credit
market (Cho, 1986). Recent contributions have proposed intuitive refinements of this
argument. For instance, institutional economists have highlighted that banking systems in
developing countries are often characterized by a high ownership structure resulting in
oligopolistic practices. In such systems, the selection of investment projects based on
expected operating results can be disturbed by strategical political interactions between
agents, which results in suboptimal investment decisions, and in a weak corporate sector. The
poor allocative performance of the bank-based financial structure then magnifies the relative
advantages of equity markets (Henry & Springborg, 2004). Other studies have underlined the
liquidity-enhancing function of equity markets. The creation of a domestic stock market in
developing countries may provide households with an additional instrument which may better
meet their risk preferences and liquidity needs (Dailami&Atkin, 1990). Domestic stock
investment may thus constitute an alternative to consumption, the purchase of land and real
estate, or the seeking of more profitable investment abroad, ultimately resulting in a higher
mobilization of savings (Oshiloya & Ogbu, 2003). Some have also underlined the role of a

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